The DB Underpin Hybrid Pension Plan

In this paper the defined benefit underpin guarantee is valued as a financial option, within the traditional funding paradigms of actuarial science. Assuming fixed interest rates, and assuming that salaries can be treated as a tradable asset, we value the guarantee using fair value principles. Contribution rates are developed for the Entry Age Normal, Projected Unit Credit, and Traditional Unit Credit funding methods. In addition, for the accruals methods, we demonstrate the implied hedging strategy. The traditional unit credit offers the best method of these three, as it is consistent with the principles of financial economics, and the resulting contributions more naturally follow the cost of the emerging benefit, without creating expensive barriers to new hires. The method generates significant contribution volatility, and we demonstrate how this can be reduced with suitable benefit design and ongoing risk management.